This mood in the equity markets these days brings to mind the fairy tale by Hans Christian Andersen, The Emperor’s New Clothes . The king along with his courtiers, soldiers and citizens had been tricked by a couple of rogues that his robe would be visible only to the clever. Although everyone could see that the king was parading with no clothes, they did not admit it.

All stakeholders know that it is the sheer liquidity, pumped by global central banks, that is powering the stock market rally since April. The fact that this rally is against the background of the worst recession in the global economy since the Great Depression and severe contraction in corporate earnings is perhaps making investors fearful that central banks could reduce the stimulus or resort to monetary tightening to douse the market rally.

These fears are however unfounded. The statements made by previous Fed Chairman Ben Bernanke and the current Fed Chair, Jerome Powell, show the Fed is more worried about the real economy rather than asset price increases caused by stimulus funds. Also, despite the stock prices run-up, valuations are hardly in the ‘bubble’ zone yet.

Will central banks cut stimulus?

Global central banks have pumped in about $9 trillion between March and May this year. While direct budget support is estimated at $4.4 trillion, public sector loans, equity injections, guarantees, and other quasi-fiscal operations account for the other $4.6 trillion according to the IMF.

Many research papers have established the link between central banks’ stimulus money and asset price inflation. This stimulus money also flows into emerging markets such as India in the form of foreign portfolio flows.

FPI flows into Indian markets had surged to ₹5,51,992 crore in the period between 2009 and 2014 as the Fed did a series of QE programmes to help the US economy recover from the GFC.

FPIs had pulled out close to ₹62,000 crore in March as equity prices collapsed. But they have pumped in more than ₹35,000 crore in May and June as stimulus-induced liquidity increased.

The question now is, with the stock price indices in the US racing higher, will the Fed and other central banks re-think their stimulus efforts and take it a little slower from here?

That seems highly unlikely. Jerome Powell made it quite clear in the press conference after the June 2020 FOMC meeting that the Fed’s principal focus is on the state of the economy, the labour market and inflation. He stated that holding back on the stimulus because asset prices are too high will hurt the people that the Fed is legally supposed to be serving.

He said, “We’re tightly focussed on our real economy goals. And we're not focussed on moving asset prices in a particular direction at all…We want markets to be working and I think partly as a result of what we’ve done, they are working.”

Ben Bernanke, in his 2002 speech on ‘Asset-price bubbles and monetary policy’, also argued along similar lines saying that a central bank’s job is not to pop bubbles, that it was anyway not competent enough to identify correctly. “Even putting aside the great difficulty of identifying bubbles in asset prices, monetary policy cannot be directed finely enough to guide asset prices without risking severe collateral damage to the economy.”

Not a bubble yet

The moot question is, is there a bubble forming in equities? Going by conventional metrics, there is no bubble in equity valuation, either in the US or in India.

According to Factset, the forward 12-month price earning ratio for the S&P 500 is 21.2; above the five-year average of 16.8 and the 10-year average of 15.1.

While the ratio has expanded due to de-growth in earnings in 2020, it is well below the highs recorded in 2000 of 24 times. In terms of dividend yield also, the S&P 500’s current yield of 1.9 per cent is higher than the lows hit in the dot.com bubble of 1.1 per cent.

If we consider the valuation in Indian stocks, the Nifty 50’s current trailing PE ratio at 22 times is well below its January high of 29 times.

Similarly, the PE ratio of Nifty midcap index at 23, is well below the January peak of 28. Current dividend yield of Nifty 50 at 1.51 per cent is also well above the 2008-low of 0.8 per cent.

The talk about a bubble in market can arise, if at all, based on the Nasdaq composite that has risen beyond its January peak. But its current PE multiple of 27, is well below last year’s peak of 31 times. Also, healthy growth in earnings of technology companies, with many of them not too impacted by the virus, supports the strong valuation.

Other reasons for the rally

Those who are bewildered by the disconnect between the economy and stock price movement need to understand that stock prices reflect future growth projections. It is, therefore, not surprising that the prices are currently rosier compared to economic reality.

There could be other reasons driving stock prices at this juncture. Most brokerages in India have reported higher trading activity and new account opening since March. It appears as if people locked in in their homes are trying their hand at stock trading, thus giving a leg-up to stock prices. A similar trend is being observed in the US, the UK and Japan, according to media reports.

The world’s wealthy, with fewer options for parking money, due to interest rates at zero and sub-zero levels in many countries and most commodity prices displaying a lacklustre trend, may have turned to equities.

Stock markets, along with US treasury instruments and gold, have, therefore, been attracting more interest of late.

The central bank stimulus has given the initial impetus to stock prices and this support is unlikely to be withdrawn just yet. But there are plenty of risks at this juncture that investors need to be aware of. If there is a second wave of infection in advanced economies or if the economic impact is greater than current projections, there could be another round of earnings downgrades that can affect stock prices.

While the liquidity provides a floor, the upside in stock prices is limited unless there is a spectacular improvement in earnings.

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